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Greece Is Just the First to Default

It's just a matter of time

Philip Coggan, aka Buttonwood, writes the financial markets column of The Economist in London. His new book, Paper Promises: Debt, Money, and the New World Order, released in the U.S. on Monday, is a sweeping examination of the relationship between debt and money since antiquity. By the same token, it's an enigma machine for deciphering the rules for investing in the post-crisis world -- rules not even the most stubborn stock picker can afford to ignore. In today's conclusion to this two-part interview series (Part 1 is here), Buttonwood discusses the likely outcome of Europe's debt crisis and whether gold is a suitable choice for investors -- or nation-states.

There is no better illustration today of the tight link between debt and money than Europe's sovereign debt crisis, which threatens the very integrity of the single currency binding 17 European nation-states. I asked Buttonwood for his base case for the way in which the crisis will play out. In a few sentences, he painted a stark scenario:

There is no way that Europe can grow out of its debt crisis given its demography. So the three options are: inflate, stagnate and default. (The second option will be followed by the third eventually.) Greece is already defaulting, although they are trying to call it something else. After that deal is pushed through, the EU will attempt to muddle through with a grand bargain, being support from the northern European nations for the south in return for pledges of austerity and reform. But the voters will not put up with prolonged austerity and will eventually force default.

Hard money advocates -- gold enthusiasts, in particular -- see the European crisis as just one more example of a fiat currency that is doomed to extinction.

The broader question is whether we should go back to a gold standard. While some people point out that all previous paper money systems have collapsed, I would counter that all metallic standards have been abandoned. That is because democracies find it too difficult to keep the value of money fixed and adjust all other prices and wages, not least because debts tend to be fixed in nominal terms.

If nations are unwilling to adopt gold as a currency, is it wise for their citizens to own it to protect their wealth against government actions?

Gold is fixed in supply. So there is some rationality in owning it when the world's central banks are trying to expand the volume of paper/electronic money. But there are other hedges against inflation such as property and index-linked bonds. The civil breakdown/end of the world argument seems unconvincing since in those circumstances you need food, oil and guns to guard them, rather than a metal.

What of the possibility that gold has gone from cheap hedge to asset bubble, in which case it has become a sound vehicle to destroy wealth rather than preserve it?

Is gold a bubble? It is awfully hard to value since it has no yield or earnings. It has risen remarkably in the last 10 years although, of course, to some extent that is remedying a 20-year period when it went backwards. Relative to oil, it is slightly below the long-term average (see this article for a long-term chart.) The main reason to worry about it, I think, is that it has reached the level of popular interest, with adverts to buy and sell gold on TV and the gold exchange traded fund becoming one of the largest holders on the planet. There is thus scope for quite a big fall if fashion changes.

Buttonwood's not wrong: In the 10-year period through last Wednesday, gold has achieved an inflation-adjusted annualized return of 16.3%. That's better than U.S. large-cap stocks' performance in the 1990s (S&P 500 Total Return: 14.8% per year). To be sure, gold still has some room to run before it equals the numbers put up by technology stocks in the 1990s, Japanese shares in the 1980s... or gold in the 1970s. Nevertheless, for those who own the metal -- whether in bullion or through exchange-traded funds such as the SPDR Gold Shares(NYSE: GLD), the iShares Gold Trust(NYSE: IAU) or the Central Fund of Canada(AMEX: CEF) -- that 10-year return figure is a red flag.

While gold may not be the right hedge, it's clear that investors should be mindful of the long-term risk of inflation resulting from the Fed's policy actions. That represents an extraordinary reversal from earlier times, for as Buttonwood mused in closing the interview:

Central bankers were once fierce guardians of the currency, believing that the money supply should be controlled and the currency fixed. Now they compete to let their currencies depreciate; the countries with floating exchange rates (America, Britain) have lower bond yields than those with fixed. In the Second World War, the Germans printed fake pound notes and dropped them in Britain as a way of sabotaging the British economy; now expanding the money supply is seen as the way to save it.